Policy

Fed Official Seeks Radical Change in Bank Regulation

Federal Reserve System Governor Daniel Tarullo testifies before the Senate on Feb. 6

The Swiss city of Basel is to central bankers what the Vatican is to Roman Catholics. But that didn’t stop Federal Reserve Governor Daniel Tarullo from slamming the Basel approach to bank regulation in a speech today in Chicago. According to prepared remarks released by the Fed, Tarullo said the standard designed by the Basel Committee on Banking Supervision creates “manifold risks of gaming, mistake, and monitoring difficulty.” The Basel standard, he said, “contributes little to market understanding of large banks’ balance sheets and thus fails to strengthen market discipline.” He even said its “relatively short, backward-looking basis for generating risk weights makes the resulting capital standards likely to be excessively pro-cyclical and insufficiently sensitive to tail risk.”

To be sure, his damnation of Basel wasn’t complete. He never said it caused high blood pressure or coastal erosion. But he did say that the Basel “approach—for all its complexity and expense—does not do a very good job of advancing the financial stability and macroprudential aims of prudential regulation.” Speaking at a Federal Reserve Bank of Chicago conference, he summed up by saying, “we should consider discarding” it, which really means “we should discard it.”

There’s a lot of bankerspeak in the above-quoted remarks, but Tarullo’s objection is simple. He doesn’t trust banks to judge their own risk exposure, which is essentially what the Basel rules allow. The part of the Basel standard that Tarullo criticizes is called the “internal-ratings-based” approach to regulatory capital. It means that banks get to use their own internal ratings of asset quality—within bounds—in determining the likelihood that a loan they made won’t get repaid, or a bond they own will go into default. Under the Basel rules, banks have a perverse incentive to underestimate the riskiness of their portfolios, because banks with safe portfolios are allowed to have thinner safety cushions of capital. Bankers don’t like to have thick capital cushions, because they feel it reduces their return on equity.

Tarullo observed in his speech that the Basel II internal-ratings-based approach failed calamitously in the 2008 financial crisis. “The IRB approach, which generally applies in the United States to all bank holding companies with $250 billion or more in assets, was developed a decade ago in an effort to align risk weightings more closely to the increasingly sophisticated quantitative risk-assessment techniques in the financial industry,” Tarullo said in his prepared remarks. “At the time of its development, the IRB approach seemed intended to result in a modest decline in risk-weighted capital requirements, a goal that the financial crisis revealed to be badly misguided.”

Recognizing their mistake, the central bankers who make up the Basel Committee on Banking Supervision have been trying to toughen the rules in a new Basel III. But Tarullo said the basic approach is still “problematic.” He puts more faith in other means of regulation—which are also being incorporated into Basel III—including stress tests. In a stress test, regulators simulate what would happen to a bank’s balance sheet in the case of some extreme event, such as a huge decline in housing prices. Tarullo also supports liquidity standards—which make banks keep some of their assets in liquid, easily sellable form in case of an emergency.

I spoke to two academic experts today about Tarullo’s speech. Anat Admati, a Stanford University Graduate School of Business professor and co-author of the The Bankers’ New Clothes, said she agreed with Tarullo that the internal-ratings-based approach is no good, but she disagrees with him that stress tests are “sufficiently reassuring.” She called them a “charade.”

Michael Jacobides, a professor at London Business School, called Tarullo’s speech “bold.” He wrote in an e-mail that the internal-ratings-based approach makes the banking system “more convoluted and easier to game, especially from the banks which would require the most supervisory attention.” Like Admati, he was concerned that Tarullo didn’t go far enough. He said regulators still rely too much on rating companies “whose business model focuses on maximizing their profits, as opposed to ensuring the systemic stability of the financial service system.”